Which is the better option? ROE or ROCE?

Julie Brownlee, Fsp Invest, 26 Oct. 2015

Tags: return on equity, return on capital employed, roe, roce, investing in shares

The whole premise behind investing in shares is to make money.

One way some investors decide which shares to buy is to work out the interest rate a company is effectively paying. You can take this figure and compare it with other investments.

Two common ways of doing this are return on equity (ROE) and return on capital employed (ROCE).

So how can you work out these two measurements? And which one is the better option to use?

Let’s take a closer look…

What is return on equity (ROE)?

Return on equity looks at a company’s post -tax profits in comparison with the money invested by its shareholders, its equity.

Let’s look at an example…

Say Company A has R100 million in post -tax profits and equity of R500 million. This means its ROE is 20% ((R100 million/R500 million) x 100).

On the other hand, Company B has R200 million in post -tax profits and equity of R2 billion. This means its ROE is 10% ((R200 million/R2 billion) x 100).

From looking at ROE, Company A is the better investment as your money will work twice as hard as it would in Company B.

But ROE does have its flaws. For instance, corporate borrowings can skew the figure for the better. This is because ROE ignores debt.

What is return on capital employed (ROCE)?

Return on capital employed is similar to ROE, but instead of focusing on equity, it focuses on capital employed.

Capital employed is a company’s total assets minus its total liabilities, so it takes debt into consideration.

As with ROE, the higher the rate of ROCE, the better for an investor.

With this in mind, ROCE is a better measurement to use as it does take into account a company’s debt or gearing. The more debt a company carries, the more risky it is.

So there you have it. Why ROCE is the better option.

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